Posts tagged with: Financial regulation

Some might answer any defense of the free economy by pointing to the housing and financial crisis that came to a head in 2008, holding it up as proof positive the free economy is a wrecking ball swinging through communities and leaving all manner of economic and cultural destruction in its wake. The financial crisis did enormous damage, but the major drivers of the crisis were a series of public policies that manipulated the market in pursuit of certain desired ends.

It all began modestly enough. The federal government built incentives into the tax code in favor of taking out a home mortgage. Many local governments also provide property tax breaks to home owners unavailable to renters. While people who are forced by circumstances to rent might question the fairness of such tax breaks, these measures are seen by most as relatively benign. Eventually, however, other top-down manipulations of the housing market were piled on top of these tax breaks.

The U.S. government offered implicit backing to mortgage giants Fannie Mae and Freddie Mac so that the companies understood that if they got into financial trouble, Washington would bail them out. This allowed Fannie and Freddie to offer low interest home loans to high risks borrowers, since the companies knew the government would come to their rescue if too many of these borrowers started defaulting on their loans.

The government also passed regulations that actually pushed mortgage companies, including Fannie and Freddie, to provide home loans to people with bad credit—subprime loans.

IF you follow free market writers closely, you known that government interventions in the financial markets, rather than too much economic freedom, fueled the housing bubble and paved the way to the subsequent housing collapse and financial crisis. Infiltrated deftly summarizes this, but it’s in two other areas where the author, former Acton research fellow Jay Richards, offers fresh insight.

The first is the way he explains how activists and politicians have used the financial crisis to double down on the same big-government hyper-regulatory strategies that got us into the financial crisis in the first place. As Jay explains, the misleadingly named “Dodd-Frank Wall Street Reform and Consumer Protection Act,” which neither reforms Wall Street nor protects consumers, is mostly just more of the misguided medicine that contributed to the crisis in the first place.

The second valuable feature of the book is its often novel-like descriptions of the characters and tactics that led from small beginnings to the Leviathan creature that is Dodd-Frank. Understanding the opposition–their strategies and appeal, their cynicisms and idealism–is crucial to mounting a successful counteroffensive.

The book explains all of this with the sort of accessible, engaging prose that characterized Richards’ previous bestseller, Indivisible, and lays out a practical blueprint for a counteroffensive.

“Richards brings a sharp analytical mind and a passion for justice to bear on the financial crisis and its aftermath.” –Arthur C. Brooks, President, American Enterprise Institute

“If you want to know why the popular wisdom about the causes and effects of the financial crisis is mosty wrong, and how such myths will help faciliatae similar crises in the future, Jay Richards’s Infiltrated is an eye=opener.” –Samuel Gregg, author of Becoming Europe and Tea Party Catholic.

Last month, in my series on Bitcoin, I wrote that for the crypto-currency to succeed it will one day have to become trusted by more mainstream consumers, which requires adding such features as regulatory oversight and a centralized monetary authority—the very features of other currencies that Bitcoin was created to avoid.

The Manhattan Institute’s Proxy Monitor project is aimed at “shedding light on the influence of shareholder proposals on corporations.” It provides a thorough analysis of proposals made from 2008 – 2011 by activist investors — and believe it or not, only 35 percent of those proposals were related to corporate governance. Most of the shareholder proposals that these companies deal with are attempts to direct the company in a more green or pacific or fair direction, and they come from small shareholders who do this to dozens of companies.

A new report from Manhattan summarizes the trends — the growing social proposals, and how Dodd-Frank has playing into activists’ activities — and the proxy monitor website allows you to look at any shareholder proposal from the last few years. The proposals are enlightening. The Sisters of Mercy of the Americas have submitted proposals to the stockholders of Lockheed Martin and General Dynamics stating,

WHEREAS: Space has served as a sanctuary where, over the years, nations cooperate rather than confront one another. Satellites save lives…

RESOLVED: Shareholders request that, within six months of the annual meeting, the Board of Directors provide a comprehensive report on Lockheed Martin’s involvement in the space-based weapons program, at reasonable cost and omitting proprietary and classified information.

The well-meaning Sisters of St. Francis of Philadelphia, in a proposal to McDonald’s shareholders that made the news earlier this year, requested that,

WHEREAS,

The Affordable Care Act, signed into law on March 23, 2010, included federal menu-labeling legislation requiring the posting of calories on fast food menu boards….

RESOLVED: Shareholders ask the Board of Directors to issue a report, at reasonable expense and excluding proprietary information, within six months of the 2011 annual meeting, assessing the company’s policy responses to public concerns regarding linkages of fast food to childhood obesity, diet-related diseases and other impacts on children’s health.

Many other equally well-intentioned proposals have been filed, including repeated requests by the Sisters of Charity of St. Elizabeth that various pharmaceutical companies restrain their prices to “reasonable levels.” The Unitarian Universalists have requested that Pepsi Co. “create a comprehensive policy articulating our company’s respect for and commitment to the Human Right to Water.”

This is not to mention the numerous environmental proposals made by religious groups, requesting that the Rights of Humanity and of Mother Earth not be violated by carbon emissions and by the use of genetically engineered plants. Take, for instance, this statement from a proposal to Du Pont’s shareholders, concerning genetically engineered crops:

The right to food requires that we place the needs of the most marginalized groups, including in particular smallholders in developing countries, at the centre of our efforts

Elise Amyx recently published an interesting post about the Dodd-Frank Wall Street Reform and Consumer Protection Act, focusing on financial regulation. Another interesting look at regulation concerns the “Ponzi scheme” that Bernard Madoff was apprehended for three years ago.

The tale begins in 2000 when Harry Markopolos, a chartered financial analyst and certified fraud examiner, submitted information to the Security and Exchange Commission’s Director of Enforcement, Grant Ward, that there were signs that Madoff was operating a fraudulent fund. However, no action was taken by the SEC until 2008, when the damage from Madoff’s fraud was already done.

For eight years, the SEC, among other government financial regulators and private news sources, refused to audit Madoff’s fund for fraud, even though, to many financial experts, it appeared obvious something illicit was occurring.

Markopolos stated, “The biggest, most glaring tip-off that this had to a fraud was that Madoff only reported 3 down months out of 87 months, whereas the S&P 500 was down 28 months during that time period. No money manager is only down 3.4% of the time. That would be equivalent to a Major League Baseball player batting .966 and no one suspecting this player was cheating” (page 9).

In addition to the SEC, Markopolos tried to alert the Wall Street Journal to Madoff’s scheme: “ … there were several points in time when he [Wall Street Journal senior investigative reporter John Wilke] was getting ready to book air travel to start the story and then would get called off at the last minute. I never determined if the senior editors at the WSJ failed to authorize this investigation” (16).

The Wall Street Journalrecently published a piece considering Markopolos and had this to say about his character: “Critics say he’s self-righteous and a little bit crazy. In his book, No One Would Listen, Mr. Markopolos describes how he armed himself should he ever meet Mr. Madoff face-to-face. He fortified his home for what he thought was the very real possibility the SEC would send a team to suppress evidence that it knew about Mr. Madoff through Mr. Markopolos’ efforts to expose him.” So, perhaps the WSJ simply thought Markopolos was exaggerating and creating a scandal where there wasn’t one.

However, Markopolos stated in his testimony that he was disgusted that “neither the WSJ nor the SEC were inclined to even pick up a phone and dial any of the leads I had provided to them” (17).

Markopolos rightly stated, in his testimony, that this “was an abject failure by the regulatory agencies we entrust as our watchdog” to take action and investigate Madoff (1).

Even more disturbing to Markopolos was that “dozens of highly knowledgeable men and women also knew that Madoff was a fraud and walked away silently, saying and doing nothing,” (24) demonstrating that, like Amyx stated, a government cannot legislate into existence morality or values (like honesty!) for citizens.

In his testimony, Markopolos added, “We can ask ourselves would the result have been different if those others had raised their voices, and what does that say about self-regulated markets?” (25)

If personal morality and self-regulation fail, which underpin the free market, and government regulation fails, what can be done?

One obvious flaw is the United States has too many regulators and too many laws, yet not much effective regulation. It seems a strange statement, but Markopolos said as much in his testimony to Congress: “Our nation has too many financial regulators. The separation and lack of connection and communication between them leaves too many gaping holes for financial predators to engage in ‘regulator arbitrage’ and exploit these regulatory gaps where no one regulator is the monitor” (29).

Criminals, like Madoff, can easily shift between regulators and regulatory jurisdictions, and avoid punishment for years, eroding faith that markets are self-correcting and self-regulatory and that individuals or the government are capable of, if called upon, preventing financial crime.

As much as over-regulation seems to be the problem, Markopolos never made the case that all regulation or oversight was unnecessary. Indeed, he recognizes that a clear, but limited amount is beneficial to keep white-collar criminals, like Madoff, at bay.

In Markopolos’ opinion, “The goal needs to be to combine regulatory functions into as few a number as possible to prevent regulatory arbitrage, centralize command and control, ensure unity of effort, eliminate expensive duplication of effort, and minimize the number of regulators to which American businesses have to answer” (30).

This reduction in size and condensing of regulation would not only eliminate wasteful, duplicative government spending, it would make current financial law easier to understand and enforce. Hopefully, this streamlining would also reduce egregious legislative overreach, like the 2,253 page Dodd-Frank bill Amyx detailed.

In the case of Bernard Madoff, self-regulation in the financial industry did not work, but neither did centralized, federal regulation. What is needed is a responsible synthesis of personal morality and government oversight.

Christians should remember, in the words of Paul in 2 Corinthians 5:10, that, “We must all appear before the judgment seat of Christ; that every one may receive the things done in his body, according to that he has done, whether it be good or bad.”

Those who ignored/aided Madoff should remember this and be reminded that, in order for society and markets to function, individuals are responsible to a higher power for protecting one another and the helpless, such as all those who lost their life savings due to Madoff’s crime, from harm.

On the regulatory side, instead of an “alphabet soup” of regulators and excessive, market-infringing regulation, a single (or perhaps a few) regulators(s) could enforce a limited amount of financial regulation to prevent fraud.

Hopefully, this would satisfy the market as there would be less regulators and regulation involved, allowing for maximum creativity and innovation in the market, while, at the same time, satisfying the socially concerned that enough is being done to prevent large-scale exploiters like Madoff from harming millions of people. Personal morality and responsibility, coupled with consistent, limited, fair oversight, would, as Proverbs 2:9 states, allow markets and businesspeople to “… understand what is right, just, and fair, and…find the right way to go.”

Dodd-Frank regulations, originally scheduled to take effect on July 16, are intended to create market stability. Instead, they are doing just the opposite.

Regulations aimed at financial derivatives, incorporated into the Dodd-Frank Wall Street Reform and Consumer Protection Act that was signed into law last July, have recently been rescheduled to take effect on December 31. The regulations are aimed at reducing the risk of derivatives, a contentious issue among those debating the root cause of the financial crisis. A Reuters’ report suggests this legislation will create uncertainty and a legal void for the derivatives market. Fears that trades could be challenged or invalidated may send the market for swaps (over-the-counter derivatives) into “legal limbo,” according to NASDAQ News.

I have concerns that this proposal will not provide the appropriate level of legal certainty, and if it is to last only a few months, will likely only serve to further confuse and frustrate the markets and market participants.

Legal delays and uncertainties are only a small part of a much larger problem. Saturated with 2,253 pages of confusing regulation, Dodd-Frank is considered to be the most drastic financial revision in 80 years.

Former U.S. Senator Judd Gregg, now an adviser to Goldman Sachs, says Dodd-Frank goes too far for our good. He argues the regulation will hurt job creation and smother economic growth:

The consequences will be a massive transfer of economic activity overseas and an equally massive contraction in the liquidity and credit that keeps U.S. business competitive and vibrant.

Though intended to stabilize the financial market, Dodd-Frank is creating more uncertainty and instability at our liberty’s expense. Regulation will harm competition and stifle individual freedom. In an attempt to correct the immoral behavior on Wall Street, the government is compromising the dignity of the individual by reducing financial choices.

In a commentary titled “Credit Crunch, Character Crisis,” Samuel Gregg, the Director of Research at the Acton Institute, discusses the financial and moral costs of similar risk-controlling regulation in the past:

A longer-term problem is that this failure may facilitate calls for more financial regulation, much as the Sarbanes-Oxley Act was a response to America’s 2000-2001 corporate scandals. The evidence is growing that Sarbanes-Oxley has proved extremely costly for business. Even Sarbanes-Oxley’s authors now concede many of its provisions were badly drafted.

According to a University of Pittsburgh study, Sarbanes-Oxley’s discouragement of prudent risk-taking and its generation of additional compliance-costs have contributed to many firms listing themselves in the City of London rather than Wall Street. This has also been facilitated by Britain’s Financial Services Authority’s shift away from Sarbanes-Oxley-like procedural approaches to financial regulation, towards principles-based regulation which focuses on (a) the behavior reasonably expected from financial practitioners and (b) good outcomes.

In the end, however, no amount of regulation — heavy or light — can substitute for the type of character-formation that is supposed to occur in families, schools, churches, and synagogues.

These are the institutions (rather than ethics-auditors and business-ethics courses) which The Wealth of Nations’ author, Adam Smith, identified as primarily responsible for helping people develop what he called the “moral sense” that causes us to know instinctively when particular courses of action are imprudent or simply wrong — regardless of whether we are Wall St bankers or humble actuaries working at securities-rating agencies.

Perhaps the recent financial turmoil will remind us that sound financial sectors rely more than we think upon sound moral cultures.

Gregg’s economic and moral analysis suggests regulation cannot build character. The implicit goal of Dodd-Frank is to achieve moral ends on Wall Street through coercive means — expanding government oversight. We must remember virtue cannot be artificially manufactured by increased regulation; rather virtue requires freedom to choose the proper course of action. Moral character in the business world should be encouraged by a proper incentive structure, but even more importantly by the values taught in our social institutions.